EU compounding confusion creates headaches for banks

With the fallback possibly illegal in some EU states, loan system updates may become more complicated

Imagine asking the smartest people you can find to build the perfect solution to a big industry problem. They do a good job and everyone thinks the solution will work.

But when it’s on the verge of rollout, pesky lawyers pop up and point out that, in fact, it might be illegal.

This is what happened in December, when it emerged that the proposed fallback rates for Euribor may be banned from use in Germany and Italy.

Regulators in Europe, as in other jurisdictions, are pushing market participants to adopt so-called fallback language that will switch existing swaps contracts to a backup rate if Euribor ends.

The fallbacks haven’t been finalised yet. The International Swaps and Derivatives Association is consulting on backup rates for swaps. If Europe follows other jurisdictions, the backup rate for Euribor would be based on a backward-looking compounded version of the euro short-term rate, plus a spread on top representing the historical difference between €STR and Euribor.

Confusingly, the euro working group is also consulting on fallbacks for Euribor-linked swaps, alongside bonds and loans, and may recommend forward-looking fallbacks based on futures and overnight indexed swap quotes.

Some European regulatory sources are privately sceptical of forward-looking rates, which can be based on quotes and seem too close to the old Libor setup

But some European regulatory sources are privately sceptical of forward-looking rates, which can be based on quotes and seem too close to the old Libor setup. So a backward-looking compounded fallback appears to be the most likely choice.

This is a problem in Italy and Germany, however, where compounded interest is explicitly banned under local law.

While fallbacks based on compounded interest have been on the menu for some time, lawyers have only recently pointed this out. A senior figure involved in the development of the fallbacks was not aware of the issue when approached by Risk.net.

The problem was raised for the first time at a December 4 meeting of the working group on euro risk-free rates.The minutes of the meeting also highlighted new concerns with the European Mortgage Credit Directive, which can be read as requiring borrowers to be informed of a change in interest rate before it takes effect. This means consent may be required before the fallback kicks in.

Euribor fallbacks could hit thin legal ice

The exact requirements vary across jurisdictions, and some countries may also bar a change in interest rate under consumer protection laws.

The Loan Market Association’s Kam Mahil stressed the urgency of the situation at the meeting, calling for a Europe-wide analysis of the legality of compounding methodologies in each member state.

With any project as large as this, some problems inevitably crop up late in the day. And with Euribor not ending anytime soon, the industry has time to find a fix.

But as Mahil points out, the US and UK are opting for compounded rates. Ideally, Europe will follow suit so the industry can develop loan systems that will deal with the problem globally.

But with the US dollar and sterling Libor rates potentially going away at the end of 2021, global banks will have to make a start on updating their loan systems relatively soon. The biggest firms won’t have the luxury of waiting around to see how Europe deals with the legality of compounded interest.